21 March 2013
The Winning and Losing Nations
Professor Douglas McWilliams
Thank you again for coming. I greatly respect those brave enough to endure an evening of economics after a long hard day creating the economic facts that these lectures seek to analyse.
Tonight’s lecture is the last in the series for my first year looking at the greatest ever world economic event. It has two parts – the first looks at which economies are likely to do well and which are likely to do badly as a result of these changes and the second – since today is the day after the UK Budget – is a quick analysis of the Budget. And I have the Cebr experts who have been looking over the Budget with a magnifying glass to find out what it really means here with me – if there are any difficult questions on the Budget I will pass them to these experts.
Just to recap, the first lecture attempted to justify the title of the series by comparing the industrialisation of China and the other two thirds of the world currently ‘emerging’ with other major economic events. The second pointed out the impact on demand for energy and other commodities. The third looked at how we needed to revisit our ways of analysing the economy in the West to understand how best to get Western economies to grow in circumstances where we have lost our monopoly of production of many products. The fourth looked at this in even more detail and pointed how – by keeping the cost of living and inflation high and hence not only making the economy uncompetitive directly but also indirectly through limiting the scale of devaluation – the UK’s high costs, particularly for energy and housing, were damaging the economy. The fifth lecture looked at the impact of China’s huge savings surplus and how this had contributed to the financial crisis and would lead to a pensions crisis.
The sunrise and sunset cycles
Before we look at the individual nations, I would like to postulate two models – a sunrise cycle and a sunset cycle.
The sunrise cycle is of countries that are doing well. They start with abundant cheap well educated labour. This enables them to keep their prices low. Remember that for much of the period of Chinese industrialisation, Chinese wages were only 5% of those in the West. A 20 to 1 cost gap gives your exports a hell of a kick start.
But it is the next stage which is important. Low labour costs enable high profits and high investment. This in turn means that productivity grows rapidly. And although as the labour surplus gets used up, the cost of labour rises, the rise in productivity enables the economy to remain competitive even at higher wages. Meanwhile another factor is at work. Rapid growth stimulates tax revenues. So it is possible to pay for both public services and public infrastructure without resorting to heavy taxation. In this way economies like Hong Kong and Singapore have much better education, health and infrastructure than we have in the UK without high taxes – in Hong Kong the top rate of tax is 15%.
The sunrise cycle of high profits, high investment, strong productivity growth and sustainable low taxation ends up with an economic nirvana where living standards and public services improve rapidly while a competitive edge is sustained. This is the sunrise cycle.
The sunset cycle is the opposite. High costs hit competitiveness. Exports falter. Growth slows. Profits and investment are squeezed. Productivity stagnates or worse. Meanwhile, high government spending leads to deficits, which are financed by higher taxation. But high taxes are peculiarly subject to the laws of diminishing returns and so growth falters and despite high tax rates, tax revenues disappoint.
Sounds familiar? This is the model which will underpin our analysis of yesterday’s UK Budget.
The sunset model may only mean slow growth. But it can get a whole lot worse and plunge into the misery cycle if the wage level at which an economy is competitive falls below the level of welfare payments. If this happens, the economy gets into a state of degeneration that only gets worse until the welfare level is cut below the competitive wage level.
The key issue is how entrenched these models are. Those who think that the world’s greatest ever economic event can be handled relatively painlessly by the West believe that the roots of the sunrise model is shallow and that democratic pressures will relatively quickly erode it. This is essentially the view of the UK’s economic establishment – the Treasury and much of the commentariat.
But they have had an appalling track record in trying to understand what is going on which led first to the badly mistaken economic assumptions underpinning Gordon Brown’s spending splurge and then to the forecasting errors that have undermined the Coalition’s attempt to deal with the budget deficit. Because the forecasts failed to show how bleak the outlook was, the Coalition’s budget cuts have been nowhere near the scale necessary to deal with the problem.
My experience living in the East helped me understand that the sunrise model was much more entrenched than might be expected by someone who lacks this experience. Moreover, the examples of Singapore and Hong Kong show that the sunrise model is still working strongly, 50 years on from the beginning of the industrialisation process and whey their GDP per capita has gone way past that of the UK. I suspect that cultural factors are at work here which is why it is likely that China will still be a high savings, high profit, high investment and high productivity growth economy for many years to come.
The consequence for the sunset economies is that their challenge is all the greater. And because, as I pointed out in my third lecture, the Western economies are facing a competitive challenge and an inflationary challenge from high and in some cases rising prices of raw materials at the same time, their scope for movement is constrained and they are therefore forced to accept much slower growth – if any – than they would like until they can implement some of the policies that I have pointed out would help to get them out of the trap.
The worst examples of the sunset model are in Southern Europe where the economies have been plunged into the model prematurely by the adverse impact of the euro. Only radical change can fix their problems.
Time to start dropping BRICs
Jim O’Neill of Goldman Sachs did the world a major service when over a decade ago he coined the term BRICs [i] to cover four economies that were moving rapidly up the world’s league table.
He drew attention to the fact that it was not only China that was emerging but also other economies and that the rise in the real price of commodities and energy would mean that commodity based economies also would benefit from this process. The past ten years have proved him to be prescient.
But now, looking forward, the BRICs countries have less and less in common, except that we in the UK export much less to all of them than we ought.
China is an unprecedented combination of an economic superpower and a developing economy.
India will be an economic superpower in 20 years’ time but is not one yet.
Russia looks increasingly likely to remain based on commodities and gangster capitalism while scaring off much foreign investment. Its fortunes will be based on energy and commodity prices and it might even reach its high water mark within the next 15 years before starting to fall back.
Brazil is a mix of an emerging economy and a commodity economy.
So the BRICs group is no longer homogeneous. It also excludes economies that we ought to be taking seriously like Korea, Taiwan, Indonesia, Turkey, possibly Nigeria and Mexico as well as smaller high growth economies like Sri Lanka which could provide exciting if niche opportunities for investors.
So we need a more sophisticated classification.
That is why I have coined three new categories:
Sunrise economies that use the sunrise model. They are likely to be consistently fast growing over the coming years; sunset economies that use the sunset model that are likely to slip down the world’s economic league table; and a third category - serendipity economies that are lucky to have the primary resources that the world wants to buy but whose fortunes will largely depend on the market prices of their prime commodity exports and whose fortunes therefore depend, not just on their own efforts but the demands from other economies.
These new categories: sunrise, sunset and serendipity are a much better basis for analysis than the BRICs category which has done well but has served its time.
Outlook to 2022
Every year Cebr produces a ranking of the world’s largest 30 economies and a prediction of where they will be in 10 years time. We call it the World Economic League Table or more informally Die Welt (since Tim Ohlenburg, who produces it, is German), though fairly quietly since that trade mark has already been appropriated. We release it each year on Boxing Day which is a good day for releases and governments around the world treat it as semi-official and issue press releases to coincide with it.
Let me categorise the economies in the World Economic League table into sunrise economies, sunset economies and serendipity economies.
First the sunrise economies. These are the usual suspects: China, India, Indonesia, Korea, Mexico, Turkey, Taiwan and Thailand. To these I would add Nigeria, which is a huge boisterous African economy and Sri Lanka which is an unusual economy in that its GDP levels have long been depressed way below where they should be and which should recover very fast now that the war against the Tamil Tigers is over.
China is the sunrise economy par excellence. It is now the unique example of an economic superpower that remains relatively poor in GDP per capita terms. Growth will slow because of demographics – its labour force is already getting smaller and its population will be declining in a few years. But we still expect growth of 3-4% even beyond the 2020s.
India is a latent superpower, held back by bureaucratic restrictions. Its labour force growth and the scale of international orientation are its two key advantages. Because of what will be by then its vastly larger population, Indian GDP is likely to overtake Chinese GDP around 2050. One of the most pernicious of the bureaucratic restrictions in India is the food distribution cartel which means that food is expensive but farmers earn little. Fixing this is the single most important reform and Manmohan Singh is trying extremely hard. The problem is that his own party is the traditional party of the food distribution cartel.
Indonesia has kept below the radar. For years under Soekarno it was a basket case, preaching fire and brimstone against the West while its economy was collapsing under incompetence and corruption. A new breed of technocrat was brought in by the military junta who ruled the country for many years after Soekarno and their competence has survived the move to democracy. As a result, Indonesia is expected to enter the world’s top ten economies by 2022.
Korea is taking the world by storm, Gangnam style. When I had lunch recently with the Minister from the Japanese Embassy we both observed that their trade bodies seemed to be active all round the world and of course companies like Samsung, LG, Hyundai and others are establishing themselves as major presences. The late Sir George Turnbull, who was MD of British Leyland before setting up the Korean car industry, told me that the way it worked was as an extension of national service – the NCOs became the foremen, the squaddies became the shopfloor workers and it all worked with military discipline. The Korean economy has momentum, though how much will depend on whether North Korea can be sorted out peacefully. At some point Korea presumably will be reunited, but under the latest Kim, this still seems far away. But unification will happen when the Chinese decide that they want it to happen.
Mexico has overtaken Brazil as the economic star of Latin America despite the tremendous problems caused by the narcotics industry. With US states voting for legalising marijuana, my guess is that the Mexicans will rethink their policies and will make an accommodation with the drugs industry, rather than fighting a war on behalf of the North Americans. They should continue to grow, with increasing political support from a US that will become itself more Hispanic and which has already involved Mexico in the North American Free Trade Area.
Turkey has the ideal deal with the EU – outside most of its laws but with complete ability to export to the Single Market. There might be a model there for us Brits. It will have to curb Islamic extremism to keep going.
Taiwan will fall ever more into the Chinese power zone. The biggest risk is a nationalist Chinese government, possibly a side effect of China becoming more democratic, that overplays its hand over unification and ends up with a trade, or even worse a real, war.
The Thai economy seems to survive despite political turmoil. But there is a risk that political uncertainty could turn into economy-busting redistribution measures that would kill the buoyant economic growth that is still moving the economy forward.
Nigeria has reached a point where the middle classes now have critical mass and both the growth rate and investment are rising. But there is a risk of Islamic extremism – already we are starting to see pogroms against Christians and this could tear the country apart.
Sri Lanka is an interesting case. For years, its GDP has been way below the levels one might expect given its excellent education record and high life expectancy. In recent years, its growth has edged close to the double digit rate that really spurs takeoff and it looks to me like a real shooting star economy. Now that the war with the Tamil Tigers is over, I expect Sri Lanka’s growth to be dramatic – the economy could treble in size in 10 years.
The sunset economies
These are essentially the US, Japan and Europe.
The US is critically dependent on whether Barrack Obama’s attempt to introduce Europe style socialism succeeds. If it does, the country will eventually lose its growth dynamic, though this could take time.
Japan is beset with a rapidly declining work force which will fall by about a quarter in the next 15 years unless there are more older workers and an increased female participation in the labour force. Whatever happens, growth will be slow.
Africa used to be the world’s biggest economic disaster zone. At least they had the consolation that many of their problems were caused by their former colonial rulers. But today, their role has been taken over by the Europeans, who cannot be consoled by the fact that their problems are entirely of their own making.
Within Europe, Germany has the most potential and is being supported by a potentially weak euro. The UK has the advantage of its own currency, but the disadvantage of having to overcome the huge debts run up when Gordon Brown was Chancellor and then Prime Minister. France is in a much bigger mess than the French seem to realise, though they have a brilliantly effective public sector. Italy is in stagnation although Silvio Berlusconi actually did rather a good job in reducing the Italian deficit before his failure to keep his trousers on at critical moments damaged his credibility.
The competitive problems in Europe are exacerbated by the euro. This is likely to overhang the economies for at least a decade and probably a generation. And there will be knockon effects for economies like the UK that currently trade disproportionately with the rest of Europe.
Russia is critically dependent on the price of oil and gas and, to a lesser extent, other primary products. While demand for energy remains high, the economy should continue to prosper. But shale gas may damage the competitiveness of the gas industry and the price of oil may not stay high forever.
Brazil has both commodity and agricultural wealth as well as a rapidly growing industrial and service economy. It is diversifying, though its economic dynamic depends on continued high prices of minerals and, even more so, agricultural products. Brazil would be a major beneficiary if the Doha Round of world trade talks is implemented.
Canada is a very exciting economy. It has used its mineral wealth well and has controlled government spending better than any other major economy. It now has lower taxes than anywhere in the US and is looking very attractive for investors. And Canada should start to be boosted in the next decade as the North West passage opens up as a trade route, at least in the summer, as a result of global warming.
I pointed out at the time of the last Ashes series that the Australian economy had already doubled in size compared with the UK economy in the first decade of the twenty first century and that this economic improvement had correlated with the decline of the Australian cricket team. The Australian government under Kevin Rudd got greedy in trying to impose mining supertaxes. He was kicked out – actually this happened the day after the Cebr report on the likely effects of his mining supertaxes on Australia was released. I’ve never known whether we were the straw that broke that particular camel’s back or not but this apparent ability to influence the fate of Aussie leaders, sounds interesting if unlikely.
The Aussie dollar has moved from being undervalued to being overvalued. But the country is full of minerals and if deals can be done with the Aborigines to allow mining in what some consider tribal lands and if the country can get back on working terms with the mining companies, the prospects remain good. The shortage of minerals is likely to be the longest lasting of the primary product shortages, which is good news for Australia. Given the current form of the Aussie cricket team which has lost its last three tests to India, I guess there is a reasonable chance that they will continue to lose the Ashes series. But I am doing extensive economic research into the issue of how economic progress relates to sporting prowess and I am giving a more detailed lecture on this subject in next year’s lecture series. But it does appear that the stronger the Aussie economy, the worse their cricket.
Saudi Arabia is an oil based economy and has oil to keep it going at very low cost of extraction for many years to come. But it is dependent on a high price for oil – breakeven is now about $90 a barrel which means that if the price falls, the economy will be much more affected than in the past. I was in the Middle East earlier this week and the message there was that the economies are very conscious that – now that many of them are spending their oil wealth – that a fall in the price of oil would hit them much harder than has been the case in the past.
Will this change in 2050?
Obviously any view for 2050 is subject to immense uncertainty.
But anyone making plans has to use some assumptions and some of our clients need to look a long way ahead. And some of the key factors – like demographics – have a surprisingly small margin of error. Others like inflation rates, GDP growth rates and exchange rates have huge margins of error.
It is still useful though to look at what we currently see as the shape of the world economy.
Our forecasts for 2050 show China and India neck and neck for the world’s largest economy. The central forecast has India just overtaking China by then, but there is plenty of uncertainty. India will have a much bigger population, China higher GDP per capita.
In third place will be the US, almost whatever happens. But whether the US is in danger of falling out of the medals table altogether will depend on the extent to which the Obama administration’s attempt to make the US more like Europe fails. If he succeeds, and makes the US into a high tax high spend economy, its growth rate could be down close to zero or worse by 2050 (though it takes a long time to wreck an economy and an equally long time to revive one) and countries like Indonesia and Brazil could be sniping at its heels. By 2050 the demographic differences between the US and Latin America, with changing demographics making the US more Hispanic, will have narrowed.
Psychologically, after spending quite a large part of its short history as the world’s number one economy and power, this relegation to being merely one of three major economies will be quite hard for many Americans to live with and an important part of the world’s history may be shaped by how the US copes with the challenge of adjustment. We should note that the US will still probably retain much of its pre-eminence in military matters because of its technological superiority, though even this is not assured.
After the US, we could see any one of Japan, Indonesia, Brazil, a probably reunited Korea and eventually Turkey. There is a reasonable chance that Indonesia could be by then the world’s 4th largest economy.
Where will Russia be? What happens to Russia depends almost entirely on oil and commodity prices and if we are right that these are probably going to be around their present level in real terms plus or minus 50%, it critically depends whether it is plus 50% or minus 50%. But the mix of corruption, bad governance and a failure to develop non commodity based industries suggests that growth could be held back. It could even be that Russia is already at or near its high water mark and may fall back relatively in the world.
There is a chance that there will be none of the Western European economies in the world’s top ten by 2050.
Europe has adopted a mix of the sunset cycle and the misery cycle as an economic model and until this is decisively rejected, any kind of economic growth is just a hope and not even a probability.
On this basis, even Germany would find it hard to stay in the world’s top ten and could be overtaken by Mexico by 2050.
I have explained on many occasions why I think it is more likely that the euro will fail than succeed – and one of my lectures next year looks at this in detail. But if the Eurozone stays together to 2050, it will have to become more cohesive to the extent to which it would probably be more realistic to treat it as an individual economy.
Equally, it seems unlikely that the richer parts of Europe will continue to subsidise the poorer parts, which has to be part of keeping the euro together, without changing the economic model. So if the euro stays together, then I would expect a slightly revitalised Eurozone to be somewhere in the middle of the world’s top ten economies.
If the euro does break up, then it is likely that Germany will adopt a more pro growth economic strategy and will probably do enough to stay in the top ten.
So the world’s largest economies in 2050 are likely to come from China, India, the US, Japan, Indonesia, Brazil, a united Korea, Turkey, the Eurozone or Germany, Russia and Mexico.
This brings us to the end of the first year’s series of lectures on the subject of the world’s greatest ever economic change. Thank you very much to those who have come to all or most of them. I hope you have found them a useful guide.
I am committed to a special lecture this year, on 1 May here starting at 6pm. This is on transport in London. I will attempt to argue that transport is too important to leave to transport economists and that many of the assumptions on which they work are outmoded. And if you used uptodate assumptions to guide policy you could reduce the cost of transport significantly.
Next year’s series of lectures will all be here and will start at the usual Gresham time of 6pm. They will cover a wide range of subjects including inequality and the euro. One of them will ask the question ‘Was Karl Marx right after all?’ And on that note I will end the main session of this lecture before turning to yesterday’s Budget.
© Professor Douglas McWilliams 2013
[i]In a Goldman Sachs paper titled ‘Building Better Global Economic BRICs’.